Funds of hedge funds see opportunities in turbulence

Date: Friday, October 12, 2007
Author: Nigel Davies, uk.reuters.com

By Nigel Davies

LONDON (Reuters) - Market turbulence has created windows of opportunity for managers of funds of hedge funds eager to scavenge profits from ongoing volatility even while they are wary of an economic downturn, a Reuters poll showed.

The quarterly survey of 12 such managers in the U.S. and Europe showed that six still see event-driven strategies as delivering the best returns in the final three months of the year, and first quarter of 2008.

The same strategy, which aims to take advantage of companies involved in takeovers, mergers or bankruptcies, was favoured in the last poll.

Yet the survey of managers, who together control $141 billion (70 billion pounds) in assets, highlighted a shift away from pure takeover activity, seen as one of the main drivers of profits in July's poll.

That has coincided with a sharp drop-off in mergers and acquisitions activity since the global credit crunch took hold in August and brought money markets nearly to a standstill.

Special situations, such as company restructurings, as well as more defensive strategies such as fixed income and global macro economic managers are coming increasingly into focus, the poll, conducted October 1-11, found.

"Volatility could well pick up going into next year and global macro managers are best equipped to deal with that," said Kris Carlo Raecke, portfolio manager at Union Bancaire Privee in Geneva.

Tightening credit conditions made it harder for leveraged deals for event strategies to prosper, but create opportunities in fixed income and distressed debt, he said.

"Default rates have not picked up, but there are a lot of securities trading at distressed prices even though the company is not distressed."

Indeed the survey showed allocations to both distressed debt and credit strategies increased in the last three months, while allocations to merger arbitrage have been reduced.

Market volatility has not stopped hedge funds enjoying a good run this year. While the average hedge fund lost 1.31 percent in August a market rebound in September saw the average fund up 2.98 percent, according to Hedge Fund Research.

This brings a gain of 9.14 percent for the year to end-September, while the average hedge fund of funds has risen by 8.45 percent. But that is still behind a 12 percent gain in the MSCI World Index in this time.

SECOND LEG TO SHORT SUBPRIME

Hedge funds appear to be among the few operators in financial markets to capitalise on a rout in the U.S. subprime mortgage market.

"While it's had a great run year-to-date, we still think being short select subprime has legs," said Mike Hennessy, a managing director at Morgan Creek Capital Management in North Carolina.

He added that there were also attractive investment opportunities for taking long positions, betting a stock will go higher, to selective senior secured bank debt.

Hedge funds have prospered in the last month on a wider market resurgence sparked by an aggressive half-percentage point cut in U.S. interest rates.

And with forecasters already expecting another cut, perhaps as soon as this month, funds could receive a further push should the Federal Reserve deliver.

"This will not only determine the evolution of the equity market in the U.S., but also the ones in Asia and Europe," said Manuel Echeverria at Optimal Investment Services in Geneva.

And while sub-prime has provided a boost to portfolios, if it sparks wider turmoil then returns will be slimmer all round.

"The most important doubt remains the impact of this re-pricing of credit over the U.S. economy. In other words, if the troubles in the housing sector cause a recession or not," said Echeverria.

Emerging markets are forecast to lead the pack in the next two quarters, carrying on the path they have set this year. HFR said the average emerging markets hedge fund has risen by 20.44 percent this year to the end of September, well ahead of other sectors.

Again this is below the 32 percent rise in the MSCI emerging markets index.